BFP #OpenLP Series — How we assess fund investments: (3) IRR
What is IRR?
IRR reflects the Internal Rate of Return, taking into consideration the capital returned and the time at which the capital flows. It is designed to take into account the time value of money, reflecting the economic concept that a dollar tomorrow is worth less than a dollar today.
How is IRR useful? What are its drawbacks?
In principle it is better to get one’s invested dollars back sooner rather than later. If a LP has a target return of, say, 2.5x on a fund investment, it is better to achieve that in 8 rather than 10 years. Therefore, assuming an equal money multiple, the manager that achieves this sooner will deliver a higher IRR.
However, in Venture Capital the world is not that simple. Companies take time to grow, and the time span to exit, particularly for early stage investing, could be a decade or more. The problem is that after that amount of time, the discounted present value of exit proceeds is, in fact, quite heavily discounted.
At Blue Future Partners, to put it bluntly, we basically ignore IRRs in the evaluation of a fund’s track record.
Take a simple example: You invest $1m in a fund and have the choice of receiving back $3m after 10 years or $4m after 12 years. Which could you choose? Very few people would probably go for the former.
Yet the IRR for both scenarios is very similar: The IRR of the former is 13.0% versus 13.4% for the latter. This reflects the fact that, according to the IRR model, today’s value of cash received in 10 years plus is negligible in today’s terms.
Particularly in the early years of a fund’s life cycle IRRs may therefore be highly misleading. Especially if they are based on the paper gains of some early up-rounds. At BFP we therefore focus on the expected long-term cash-on-cash return (i.e. net money multiple) instead.